Arnold Kling  

Regulatory Arbitrage, AIG Edition

Since You Asked... Who Said It?...

In an email, Houman Shadab writes,

AIGFP was treated as a bank for its counterparties' risk-weighting purposes, but AIGFP was not regulated as a bank (or an insurance company) for its own CDS credit exposures (had it been, it would've had to set aside capital/reserves)

This sounds like a great way to make capital requirements magically vanish.

Houman has an outstanding paper in the works on credit default swaps, and when he has a version that's on line I'll be sure to link to it.

Something tells me that the hue and cry over AIG executive bonuses is nothing more than an attempt to distract attention away from the larger issue of a bailout that should never have taken place in the first place. In the name of "protecting the financial system," the government used AIG as a conduit to funnel taxpayer money to not-so-deserving counterparties who participated in this game of hide-and-seek with capital requirements.

UPDATE: The whiff of scandal grows stronger. Thanks to Nick Schulz for passing this one along.

UPDATE 2: Michael Lewis adds more. Thanks to Russ Roberts for the pointer.

In a follow-up email, Houman quotes from a March 2, 2009 10K filing from AIG:

A total of $234.4 billion (consisting of corporate loans and prime residential mortgages) in net notional exposure of AIGFP's super senior credit default swap portfolio as of December 31, 2008 represented derivatives written for financial institutions, principally in Europe, for the purpose of providing regulatory capital relief rather than for arbitrage purposes. These transactions were entered into by Banque AIG, AIGFP's French regulated bank subsidiary, and written on diversified pools of residential mortgages and corporate loans (made to both large corporations and small to medium sized enterprises). In exchange for a periodic fee, the counterparties receive credit protection with respect to diversified loan portfolios they own, thus reducing their minimum capital requirements.

The regulatory benefit of these transactions for AIGFP's financial institution counterparties is generally derived from the terms of the Capital Accord of the Basel Committee on Banking Supervision (Basel I) that existed through the end of 2007 and which is in the process of being replaced by the Revised Framework for the International Convergence of Capital Measurement and Capital Standards issued by the Basel Committee on Banking Supervision (Basel II). Prior to the adoption of Basel II, a financial institution was required to hold capital against its assets, based on the categorization of the issuer or guarantor of the assets. One of the means for a financial institution to reduce its required regulatory capital was to purchase credit protection on a group of its assets from a regulated financial institution, such as Banque AIG, in order to benefit from such regulated financial institution's lower risk weighting (e.g., 20 percent vs. 100 percent) that is assigned to those assets under Basel I. A lower risk weighting reduces the amount of capital a financial institution is required to hold against such assets.

Comments and Sharing

COMMENTS (5 to date)
Brian writes:

Well said, Dr. Kling.

jck writes:

"AIGFP was treated as a bank for its counterparties' risk-weighting purposes,.........."
Sorry, false, regulatory capital relief works only if booked through an OECD bank, and that's just what AIG did by booking the trades through Banque AIG a french regulated bank.
"the government used AIG as a conduit to funnel taxpayer money to not-so-deserving counterparties who participated in this game of hide-and-seek with capital requirements."
the american taxpayer has paid nothing for reg cap arbitrage, AIG has to pay realized credit losses and they aren't any to speak of.
Recommended reading: AIG annual report.

ck writes:

Arnold, you have an acute case of "smart person's myopia."

Not one person in 50 could tell you what "arbitrage" is, let alone "regulatory arbitrage."

Even if something dastardly happened with regard to the latter practice, people just can't get there head around it.

People CAN understand $165 million bonuses. The outrage was real.

Jesse writes:

Um, where is the scandal here? AIG found a hole in the regulations to sell unregulated insurance products. Since when is "regulatory arbitrage" necessarily a bad thing? Two years ago it would have been celebrated as a sign of the brilliance of modern finance. When companies move certain operations overseas to escape country-specific taxes and regulations, I thought the party line is that this shows the futility of the regulatory state, not that finance is inherently evil.

Sheldon Richman writes:

Regulatory arbitrage in itself is a good thing. Today's problems are purely the result of the underlying toxicity created by federal housing policy, with some sort of help from the Fed. Regulatory arbitrage is inevitable and eternal. The regulators can't see or anticipate everything (and have little incentive to anyway), while entrepreneurs can profit by spotting what the regulators overlook. That leaves us only two real choices: Keynes's "socialisation of investment," which offers no hope because political dunderheads unguided by true market prices will be in charge, or the full bite of market discipline -- no regulations, no guarantees (i.e., laissez faire).

It's really an easy choice.

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